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vertical integration

Govind Hariharan and Sean Hopkins

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Vertical integration refers to the expansion of a firm into earlier or later stages in the production process. For example, when General Motors decides to manufacture car radiators in its own plants instead of purchasing them from external sources, it is vertically integrating. There are two types of integration. Forward (“upstream”) integration occurs when a firm decides to produce a product or service that uses this firm's product or service as an input (e.g., GM starts selling cars at company‐owned dealerships). Backward (“downstream”) integration ( see backward integration ) occurs when one firm decides to produce the inputs itself rather than purchasing them from outside sources (e.g., GM producing radiators). The distinguishing feature of any vertical integration is the replacement of a market purchase by an internal transfer. This could occur as a result of the acquisition of other firms or as an expansion within a firm. Assuming that firms are organized for the purposes of earning profits, a primary reason for replacing a market exchange with an internal transfer should be that, for that particular input, the latter mechanism is less expensive than the former. Nobel economist Ronald Coase was interested in finding out why people organize production activities in the hierarchical structure of the firm ( see hierarchy ) and coordinate their decisions through a central authority ... log in or subscribe to read full text

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